Federal Reserve to buy billions in bonds

NEIL IRWIN, Washington Post

Published 5:30 am, Thursday, November 4, 2010

WASHINGTON — The Federal Reserve announced plans Wednesday to pump hundreds of billions of dollars into the U.S. financial system, an expansive and unconventional new effort to try to get the sputtering U.S. economy on track.

The Fed will, in effect, print money to buy Treasury bonds - an extra $600 billion worth by June 2011 - in a bid to lower long-term interest rates. The action should make it cheaper for Americans to borrow money, take out mortgages or refinance their houses, and for businesses to borrow funds in order to expand.

Although widely anticipated, the move was bolder than analysts had predicted. Still, some investors had expected the Fed might announce an even more aggressive package of bond purchases, and interest rates rose on financial markets Wednesday following the announcement. The yield on 30-year Treasury bonds jumped 0.17 percentage points to 4.04 percent.

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The financial markets had priced in the Fed's move for weeks, and stock indexes didn't move much after the announcement. The Dow Jones industrial average gained 26.41 to 11,215.13, still its highest close in two years. Its previous high for 2010 of 11,205 was reached on April 26.

Benchmark oil rose 79 cents to close at $84.62 on the New York Mercantile Exchange. Natural gas fell 3.4 cents to $3.836 per million British thermal units.

In a statement accompanying the decision, the Fed's policymaking committee emphasized that the action - a step known as "quantitative easing" - was driven by stubbornly high unemployment and ultra-low inflation.

Information on the economy received by Fed members since the last policy committee meeting in September "confirms that the pace of recovery in output and employment continues to be slow," the Federal Open Market Committee statement said.

The statement also made clear that the Fed will keep its options open, potentially extending the purchases if the economy continues to underperform or even reducing them if growth were to spike. The Fed kept its benchmark interest rate at zero to 0.25 percent, where it has been since December 2008

The bond purchase is the central bank's second recent foray into the realm of unconventional policy measures. During the financial crisis, in late 2008 and early 2009, it unveiled a first round of asset-buying to try to stimulate growth. Those purchases ultimately amounted to more than $1.7 trillion.

If the Fed's latest strategy works as planned, it will help strengthen an economy that has been stuck in a pattern of growth too slowly to bring down joblessness. Yet even many advocates of the approach stress that it is no cure-all. Its ultimate impact on the economy depends on whether consumers and businesses respond to lower interest rates by buying and investing. If they continue sitting on cash, the effect could be minimal.

"Bottom line: The plan provides a boost to the economy's growth, but it is not going to solve our problems," said Mark Zandi, chief economist at Moody's Analytics. "Even with the Fed's action, we're going to feel uncomfortable about the economy in the next six to 12 months."

Risks in Fed's plan

Moreover, the Fed's new path has risks. Inflation could spike down the road, creating bubbles in the stock market or housing prices, or causing the dollar to decline rapidly. For these reasons, several top Fed officials have expressed resistance to the move, including Thomas Hoenig, president of the Kansas City Fed, who dissented Wednesday.

Wednesday's action is a recognition by the central bank that it is falling short on both of the mandates with which it is legally charged - maintaining maximum employment (the national jobless rate was 9.6 percent in September) and keeping prices stable (Fed officials view 2 percent inflation as best for long-term price stability, not the 1 percent of late).

Inflation good?

Indeed, Fed officials, including Chairman Ben Bernanke, have explicitly emphasized that pushing inflation a bit higher is one of the goals behind the new action.

With the Fed's target for short-term interest rates near zero, the central bank has turned to unconventional means to try to boost growth and get inflation more in line with its goal. In this case, it is expanding the money supply by essentially printing money in order to buy bonds.

Bernanke has also stressed that monetary policy cannot be viewed as a sole solution to the nation's economic woes.

"Central bankers alone cannot solve the world's economic problems," he said in a late August speech.

Much of the effects of the new policy are already being felt. As investors have anticipated the Fed action, the stock market has risen about 12 percent, mortgage rates have decreased, inflation expectations have risen, and the dollar has fallen relative to other currencies.

Those are exactly the results one would expect if the strategy works as planned.